Alternative investments
October 31, 2022

Hedge Funds: A look back at third quarter 2022 and what may happen next

October 31, 2022
Michael Stein
Global Head of Hedge Fund Research and Management
Michael Yannell
Head of Hedge Fund Research
SUMMARY

Investors faced continued headwinds during the third quarter of 2022 as global central bank tightening caused equity, fixed income, and credit markets to sell off.


While we recognize that hedge funds are not a uniform asset class and have a wide range of objectives, overall hedge funds during the third quarter of 2022 protected capital on a relative basis versus equity, fixed income, and credit indices.

What happened? A third quarter 2022 hedge fund sector summary

Challenging markets

Investors faced continued headwinds during the third quarter of 2022 as global central bank tightening caused equity, fixed income, and credit markets to sell off. In fact, the second and third quarters produced two of the ten largest declines for the global 60/40 index (60% MSCI World Index/40% Bloomberg Barclays Aggregate Bond Index) on record, and the drawdown in US high yield bonds is now second only to the 2007-2008 decline during the Global Financial Crisis.1

While we recognize that hedge funds are not a uniform asset class and have a wide range of objectives, overall hedge funds during the third quarter of 2022 preserved capital on a relative basis versus equity, fixed income, and credit indices. This aligns with our general expectation for the potential to provide diversification to traditional markets.

 
Figure 1 | 2022 hedge fund versus long-only index returns
 
Source: Bloomberg, HFRI, MSCI, as of September 30, 2022; Past performance is not indicative of future returns. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Real results may vary.
 

Performance dispersion in volatile markets

It’s important to consider how distinct hedge fund strategies performed during the third quarter 2022.

As expected, there has been significant dispersion between strategies, with flat to positive performance from typically diversifying strategies that have little to no correlation to risk assets, such as macro and relative value strategies. Meanwhile, directional strategies that are correlated to risk assets, such as equity long/short and event-driven, have displayed a degree of downside participation.

 
Figure 2 | 2022 returns of various hedge fund strategies (as of September 30, 2022)
 
Source: HFRI, as of September 30, 2022; Past performance is not indicative of future returns. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Real results may vary.
 

Hedge fund strategy breakdown (YTD through Q3 2022)

Given the declines in global equities and high yield markets so far in 2022 through the third quarter, directional hedge fund strategies have seen losses. These directional strategies have historically tended to operate with a certain amount of beta to broader markets while seeking to generate alpha and strong risk-adjusted returns. Even within broader strategy groupings, we have seen varying outcomes this year depending on the sub-strategies pursued.

  • EQUITY LONG/SHORT | For the period, we have seen market neutral strategies help preserve capital and, in some cases, generate gains while strategies with higher net exposures and a tilt toward growth sectors such as technology and biotechnology have underperformed. We would note that technology and healthcare hedge funds have been robust performing equity strategies over the past 5 years, as these sectors have benefitted from long-term secular tailwinds and elevated intra-sector dispersion that proved beneficial for stock picking.
  • EVENT-DRIVEN | Merger arbitrage strategies have been able to profit year to date through the end of the third quarter 2022 from capturing spreads in announced M&A transactions while, at the other end of the spectrum, shareholder activist strategies have experienced declines inline with equity markets. Given the high levels of net exposure within activist strategies, we evaluate these returns through the lens of the equity market, and certain managers have been able to add meaningful alpha over time through managing concentrated portfolios and engaging corporations to unlock value. 
  • CREDIT | Overall, credit strategies have broadly outperformed global high yield markets across a number of disciplines including distressed, convertible bond arbitrage, and structured credit. Structured credit funds have particularly stood out for seeking capital protection through active management and credit selection by focusing on seasoned, floating-rate asset-backed securities. Historically, structured credit markets tend to be less efficient, allowing managers with skilled trading and underwriting capabilities the ability to outperform.

Diversifying hedge fund strategies, on the other hand, have more uniformly outperformed other hedge fund strategies during this same time period by taking advantage of heightened market volatility across financial markets through both directional and non-directional trading. This has provided validation for investors focused on a range of absolute return strategies.  

  • RELATIVE VALUE | These funds, which typically take advantage of shorter term mispricings across a range of strategies and asset classes, have benefitted from higher levels of volatility in 2022 which has translated into an attractive trading backdrop. We have seen this particularly within the fixed income market given the volatility created by central bank tightening.
  • MACRO/CTA | Discretionary macro and CTA (Commodity Trading Advisor) trend-following funds have been high returning strategies this year as shifting macroeconomic policy has translated into large directional movements in various markets including selloffs in fixed income and equities and rallies in commodities and the US dollar. Performance of CTAs has suffered as central bank intervention and corresponding market reversals has often been pointed to as a reason why these strategies have seen limited and volatile performance since 2008.2 For his reason, CTAs may see more challenging periods where there are fewer sustained trends.

Overall, while certain strategies such as event-driven and equity-long short have underperformed others, in general we’ve seen various strategies within the hedge fund industry deliver relative outperformance and even positive absolute performance amidst very challenging financial markets in 2022. This has provided further evidence that having a well-diversified portfolio, that includes various hedge fund strategies, and thoughtful portfolio construction is critical.

What’s next? A bond picker’s market

Potential opportunities for various hedge fund strategies in the fixed income arena

Proponents of active management have frequently touted the idea of a “stock picker’s market” – that over the long term, fundamentals will dictate performance of individual equities, and that after periods of high correlation, managers with expertise in security selection will take advantage of differentiation between winners and losers – but we rarely hear the same in fixed income.

But why? Should it be the case that stocks present better opportunities for active management versus bonds?

One might assume that this is because the stock market is larger and more active than the fixed income markets that they simply afford more opportunity. This, however, is simply not the case – the global fixed income markets are nearly identical in size to the global equity markets with both over $120 trillion in size, but fixed income typically has annual issuance of 20x that of equity securities.3

 
Figure 3 | Global fixed income and equity issuance
 
Source: Securities Industry and Financial Markets Association (SIFMA), as of December 31, 2021 Global Long-Term Fixed Income Issuance includes securities with maturity >13 months; includes corporate, municipal and sovereign issuance, Global Equity Issuance includes rank eligible, non-convertible IPOs and follow-on equity deals; excludes preferred shares, rights issued, closed end funds, business development companies, and special purpose acquisition companies.
 
If not market size and issuance, perhaps it is volatility. Stocks have historically seen bigger swings, creating potentially attractive entry points for expert stock pickers. However, while stocks and bonds are both negative in the most recent 12-month period, fixed income volatility has seen a larger, and consistently higher, spike up. As shown in Figure 5, while equity performance has been negative, equity volatility (measured by the VIX index) has been more in-line with historical norms versus the outsized rise in volatility we’ve seen in fixed income (measured by the MOVE index).
 
Figure 4 | Total return (last 12 months)
 
Source: Bloomberg, as of September 30, 2022; Past performance is not indicative of future returns. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Real results may vary.
 
 
Figure 5 | Equity and fixed income volatility (last 12 months)
 
Source: Bloomberg, as of September 30, 2022; Past performance is not indicative of future returns. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Real results may vary.
 
These dynamics support why we believe that we are in, and will continue to see, a “bond picker’s market,” and that various hedge fund strategies may be key to finding potential opportunities therein. These include:
  • FIXED INCOME RELATIVE VALUE | We believe strategies that specialize in analyzing potential opportunities in the liquid fixed income markets such as sovereign debt and agency mortgage-backed securities should continue to see an attractive opportunity set. With the US Federal Reserve and other global central backs backing away from quantitative easing and bond buying programs, price discovery will be important and volatility, which had been more suppressed due consistent buying by central banks across sectors and maturities, may remain high.
  • HEDGED MACRO | Traditional global macro strategies can go through “boom and bust” cycles as they seek to identify and profit from a limited number of large bets on economic themes. Alternatively, hedge funds that seek hedged trading opportunities, informed by macroeconomic analysis, have historically been able to generate consistent returns without large swings in correlations to markets. We believe that such strategies are well positioned to take advantage of trading within fixed income and currencies given the current market backdrop, especially with the challenges faced by central banks in balancing inflation and growth concerns.
  • STRESSED AND DISTRESSED DEBT | Global bond yields have risen sharply in 2022, amidst rate hikes from central banks and credit spread widening, driven by investor speculation regarding the potential for recession in 2023. These dynamics have led to a significant increase in the universe of below investment grade debt trading at stressed prices. These credits seek higher total return potential, including fallen angels and BB/B-rated debt. High yield bond and loan issuance through Q3 are down -78% and -61% compared to the same period in 2021, respectively.4 The slowdown in capital markets activity is providing opportunity for managers to step in and work with companies on strategies such as anchoring financings and initiating exchanges to address either capital needs or debt maturities. Further, while corporate default rates have remained below historical averages given the low interest rate environment and positive economic backdrop, we believe it is likely that defaults increase as capital is more expensive and harder to access. As such, we believe there will be potential for increased opportunities for managers with distressed experience in the coming year, though restructuring expertise will likely be critical as managers who can influence the process can avoid the risk of low recoveries on defaulted debt.
 
Figure 6 | Historical high yield and loan default rates
 
Source: Citi Research, Moody, as of September 30, 2022
 
 
Figure 7 | High yield distress is accelerating
 
Source: Citi Research, Citi Leveraged Loan Tracker, FTSE Indices, as of September 30, 2022
 
  • MULTI-SECTOR CREDIT | Even during less volatile market periods, there has been significant dispersion between various fixed income and credit sectors. Increased yields across fixed income and credit sectors may present an attractive entry point across various sub-sectors, but managers with tactical expertise, who are able to actively rotate their allocations, may benefit from an evolving opportunity set impacted by both macroeconomic policies and sector-specific fundamentals.
 
Figure 8 | Fixed income sub-sector returns, 2012-2022 (as of September 30, 2022)

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
CLO Debt
29.7%
CLO Debt
10.8%
Non-Agency RMBS
6.7%
Non-Agency RMBS
3.3%
High Yield
17.1%
Non-Agency RMBS
9.6%
US CMBS
4.6%
High Yield
14.3%
High Yield
7.1%
US CMBS
6.5%
Bank Loans
-3.3%
Non-Agency RMBS
25.9%
Non-Agency RMBS
8.9%
US CMBS
6.3%
EM Debt
1.3%
CLO Debt
11.2%
CLO Debt
8.8%
Non-Agency RMBS
3.0%
EM Debt
13.1%
EM Debt
6.5%
Non-Agency RMBS
5.9%
Non-Agency RMBS
-4.7%
US CMBS
24.8%
High Yield
7.4%
EM Debt
4.8%
US CMBS
0.7%
Bank Loans
10.2%
EM Debt
8.2%
Bank Loans
0.4%
US CMBS
11.3%
CLO Debt
5.5%
High Yield
5.3%
CLO Debt
-7.2%
EM Debt
17.9%
Bank Loans
5.3%
CLO Debt
3.4%
CLO Debt
0.0%
EM Debt
9.9%
US CMBS
7.9%
CLO Debt
-0.7%
CLO Debt
8.9%
Non-Agency RMBS
3.3%
Bank Loans
5.2%
US CMBS
-12.3%
High Yield
15.8%
US CMBS
4.0%
High Yield
2.5%
Bank Loans
-0.7%
Non-Agency RMBS
5.4%
High Yield
7.5%
High Yield
-2.1%
Bank Loans
8.6%
Bank Loans
3.1%
CLO Debt
4.3%
High Yield
-14.7%
Bank Loans
9.7%
EM Debt
-4.1%
Bank Loans
1.6%
High Yield
-4.5%
US CMBS
3.8%
Bank Loans
4.1%
EM Debt
-2.5%
Non-Agency RMBS
5.4%
US CMBS
-0.9%
EM Debt
-1.7%
EM Debt
-20.5%
 
 
 
Source: EM Debt represented by Bloomberg Emerging Markets Hard Currency Aggregate Index. US CMBS represented by ICE BofA BBB US Fixed Rate CMBS Index. High Yield represented by Bloomberg US Corporate High Yield Bond Index. Bank Loans represented by S&P/LSTA Leveraged Loan Total Return Index. Non-Agency RMBS represented by Citi RMBS Returns Doc - Overall Market - Nominal returns. CLO Debt represented by CLO BBB Unhedged (USD) DAILY TOTAL RETURN. Past performance is not indicative of future returns. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Real results may vary. Please see glossary for a full description of indexes shown.
 

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1 Bloomberg, as of September 30, 2022

2 From January 2009 to December 2021, the HFRI Macro: Systematic Diversified Index returned 1.4% annualized. For illustrative purposes only. Indices are unmanaged. An investor cannot invest directly in an index.

3 SIFMA, as of September 30, 2022

4 Source: Citi Research, S&P/LCD, as of September 30, 2022

Glossary

Diversifying and Directional are internal descriptors based on a fund’s strategy and objective that the Hedge Fund Research and Management team (“HFRM”) has developed and uses to categorize hedge funds. Such descriptors have not been approved by the portfolio managers noted above. The internal classification is subject to change without notice to investors. Many of the portfolio managers offer multiple products that could have different objectives or classifications from those shown above. Certain of the above referenced managers offer funds that are only available through a Citi advised feeder. Please review the fund’s particular confidential offering memorandum for more details.

These internal classifications are based on the analysis and subjective views of HFRM. The internal classification is subject to change without notice to investors and there is no guarantee that the funds will perform as described above. It is important to note that the market strategies described above may not completely eliminate market risk. There is no guarantee that hedge funds classified as “Diversifying” and “Directional” will perform as described above. Hedge funds should not be invested in based on their internal classification and other assets in a client’s overall portfolio should be taken into consideration before an investment is made.

Hedge funds can be highly illiquid and are not suitable for all investors. Investing in Alternative Investments is intended for experienced and sophisticated investors only who are willing to bear the high economic risks of the investment. Investors should carefully review and consider potential risks before investing. Additional information can be found in a fund’s confidential private placement memorandum. These risks may include:

  • loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices;
  • lack of liquidity in that there may be no secondary market for the fund and none is expected to develop;
  • volatility of returns
  • restrictions on transferring interests in the fund;
  • potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized;
  • absence of information regarding valuations and pricing;
  • complex tax structures and delays in tax reporting;
  • less regulation and higher fees than mutual funds; and
  • manager risk.

Individual funds will have specific risks related to their investment programs that will vary from fund to fund.